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Muddy waters for limited partner self-employment taxes get muddier

TAX ALERT
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April 18, 2017

Don Susswein

Three tax court decisions, several chief counsel advice (CCA) memorandums, longstanding and controversial proposed regulations that have never been finalized, and a statute that was originally enacted as a ‘loophole closer’ but now provides an arguable loophole because of unrelated statutory changes, have left the treatment of ‘limited partners’ under the self-employment tax very muddy.

On April 14, 2017, the Tax Court released their opinion in Vincent J. Castigliola, et ux., et al., TC Memo 2017-62. In Castigliola, the Tax Court ruled that a member of a state-law professional limited liability company (and, by suggestion, a member of any tax-law partnership) could not qualify for the limited partner exemption from self-employment tax if they share in control of the partnership. We believe this is a further turn away from legislative intent, as well as prior IRS and Tax Court pronouncements.

Nevertheless, it is useful to review the history in this area and where the latest cases fit in.Here is a review of the bidding and the latest developments.

Limited partners in state-law limited partnerships

Overview

Under the terms of section 1402(a)(13), which was originally enacted to make it more difficult for a limited partner's distributive share to qualify as self-employment income, any income of a limited partner other than guaranteed payments for services is exempt from self-employment tax. For example, a profits interest in 20 percent of the firm’s net income that is granted to a service partner in a state-law limited partnership solely in exchange for services, commonly referred to as a carried interest in certain industries, is exempt from self-employment tax—and does not give rise to social security benefits—under any reasonable reading of the statutory language. By statute, guaranteed payments for services performed by limited partners are ineligible for the statutory exclusion, but this restriction would make no sense if Congress had intended all payments for services performed by limited partners to be ineligible for the exemption. See our article, Limited partners and the self-employment tax.

Additional details

In 1997, the Treasury proposed regulations[1] that would have denied the exclusion to limited partners who provided substantial services to the partnership, or any services to certain ‘service’ partnerships like law and accounting firms. However, the regulations were controversial and were never finalized. They were also of questionable validity as applied to partners in true, state-law limited partnerships, given the clear language of the statute.

Interestingly, even under the proposed regulations, a limited partner in a limited partnership—who in his capacity as a limited partner was not providing prohibited services and not exercising managerial control—could simultaneously hold an interest as a general partner, and as such provide services, in his capacity as a general partner, and exercise managerial control over the partnership as general partners do, by definition. In addition, an individual who was both a limited partner and a general partner would obviously lack limited liability, in any meaningful sense, because his status as a general partner would make all of his assets subject to the claims of creditors. Thus, as long as the taxpayer was willing to go through the formalistic hoops created by the proposed regulations, establishing multiple classes of interests, and was able to demonstrate that his investment returns as a limited partner, including a limited liability company (LLC) or limited liability partnership (LLP) member, were the same as the returns paid to a substantial number of limited partners who were pure investors, in that they did not exercise control or provide prohibited services, it did not matter that the particular individual involved actually lacked limited liability and exercised the power to control and bind the partnership.

This formalistic distinction between the powers and responsibilities of an individual as a limited partner and as a general partner in the same partnership was apparently required by the legislative history to section 1402(a)(13), which stated explicitly that an individual could hold both limited partner and general partner interests, and only the distributive share attributable to the former would be exempt. This may seem strange until it is remembered that the statute was viewed as a loophole closer trying to limit the extent to which limited partners could treat their income as self-employment income and thus qualify for social security benefits that, at the time, were disproportionately large compared to the taxes paid on that income.

Years later, when social security self-employment taxes began to be imposed, at 2.9 percent on amounts in excess of the social security wage ceiling (approximately $120,000 in today's dollars) without generating any additional social security (or Medicare) benefits, the ability to exclude limited partner income from self-employment income became an arguable loophole for partners seeking to avoid the 2.9 percent tax on self-employment income in excess of the wage ceiling, or the 0.9 percent tax on such income, if earned by certain high income taxpayers, imposed by the Affordable Care Act. Nevertheless, Congress never amended the provisions of section 1402(a)(13) that continue to reflect the original view that qualifying a limited partner’s income as self-employment income is a benefit, not a detriment.

Members in LLCs and partners in LLPs

Although the Treasury’s proposed regulations were sufficiently controversial that they were never finalized, the Tax Court and the IRS have sought to apply similar policies, limiting the exclusion to investment-type income, in the case of LLCs and LLPs. Unfortunately, the actions of the IRS and the Tax Court have not clarified the law for owners of such entities.

Fortunately, the IRS maintains a policy of following its own proposed regulations[2], to the taxpayer’s benefit, as long as the taxpayer is four-square within their language. Accordingly, taxpayers are well-advised, in the case of LLCs or LLPs, to ensure that they qualify under the proposed regulations by ensuring that (1) any interest of an LLC member or LLP partner purporting to be the interest of a limited partner should not enjoy any managerial rights, although a separate interest may be held pursuant to which managerial rights are held and services are performed, and (2) the purported limited partner interest should have terms that are identical to the terms of interests held by a substantial number of investors who are not, in any way, providing prohibited services to the entity (generally, services of less than 500 hours to a non-service partnership would be permissible) or exercising managerial control. In this fashion, only income of an investment nature would be excluded.

Alternatively, relying on some language in the Tax Court's decision in Renkemeyer[3], taxpayers should be able to demonstrate that a portion of their income is clearly of an investment nature, and not compensation for personal services. The opinion in Renkemeyer suggests that such income could be exempt, even in the case of an LLC or LLP. The recent opinion in Castigliola suggests the same thing, but not for a partner whose interest is that of a ‘managing member’ holding managerial rights. Accordingly, wherever possible, any managerial rights should be held through a separate interest and consideration should also be given to avoiding member-managed structures generally. In addition, if possible, any services should be performed in the individual's capacity as the holder of such a separate interest. This is essentially tantamount to compliance with the proposed regulations, other than the requirement that the limited partner interest be held by a ‘substantial’ number of investors who neither perform prohibited services nor exercise control.

The IRS, in CCA 201640014, issued on Sept. 30, 2016, appears to take an even tougher view, rejecting the argument that an LLC member’s bona fide capital investment returns were exempt from self-employment tax, if that individual was also active in the business and exercising managerial authority. As indicated, this is a more restrictive position than the proposed regulations that would effectively allow for the bifurcation of returns on a capital investment and returns for services or the exercise of managerial authority or control. Again, this formalistic focus on managerial control seems difficult to justify in light of the fact that both the proposed regulations and the underlying statute's legislative history, permit a limited partner to also hold an interest as a general partner (obviously giving that individual unlimited liability and managerial control). Nevertheless, since the underlying purpose and role of statute has changed, as other aspects of the social security tax system have changed, the IRS and the courts might be excused for exalting form over substance in the case of an LLC or LLP.

What should the IRS, Treasury and/or Congress do?

As a matter of good tax policy and sound tax administration, some may ask what the IRS should do with the existing uncertainties. Consistent with the statute and underlying policy of the proposed regulations and the apparent policy of Renkemeyer, it might be suggested that the IRS effectively apply a standard, to LLCs and LLPs, similar to that applicable to S corporation owners. S corporation income is statutorily exempt from self-employment taxes, but any shareholder providing services to the entity must be paid reasonable wages therefor, or risk having a portion of his or her S corporation income recast as disguised wages subject to FICA taxes. To the extent an LLC or LLP owner can demonstrate that its distributive share is not attributable to the performance of services (whether that is done directly or indirectly by showing that reasonable compensation has been paid for any and all services, and subjected to self-employment taxes or FICA taxes) a similar result should apply. It should not be necessary for the taxpayer, if he exercises managerial control, to do so formally through a distinct managing member or managing partner interest—as suggested by the proposed regulations and Castigliola.

In the case of state law limited partnerships, the IRS should construe the highly restrictive provisions of section 1402(a)(13) literally: as long as the individual limited partner is receiving, as a limited partner, a distributive share and not a guaranteed payment for services, the distributive share should be exempt, even a non-guaranteed amount paid for services; to the extent the individual also wishes to exercise managerial control (or to give up limited liability) he should be permitted to do so, consistent with the statute and legislative history, as long as that is done through the holding of a distinct general partner interest.

If Congress wishes to change the rules for limited partners, to conform them to the above-described rules for LLCs and LLPs, it should do so by statute. Neither the IRS nor Treasury appear to have the authority to do so.

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